How new tax code affects individuals

What does the proposed Direct Taxes Code hold for the common man? A look at visible effects and implications of the proposals on our monies.

The draft of the Direct Taxes Code bill 2009 and the Discussion paper have been made public recently. In the words of the finance minister "the thrust of the code is to improve the efficiency and equity of our tax system by eliminating distortions in the tax structure, introducing moderate levels of taxation and expanding the tax base".

A very valuable input from the finance minister has been "It will specially meet the aspirations of our young and professionally mobile population. So what exactly is all the excitement about and will it really "change" things as they are?

What does it say about income tax rates?

The most remarkable point which would be a great cheer for all individuals is the revision in the income tax rates. The change is not only in terms of the slabs but also the simplicity in calculations. The Code proposes to create 4 slabs for the sake of income tax calculations.

For Men

Slab 1: Total income is lesser than Rs 160,000

The income tax for the above slab is proposed to be nil. This is what currently exists and hence does not in any way change anything for individuals earning below 160,000.

Slab 2: Income is between 160,001 and Rs 10,00,000

This is the most drastic change proposed. The tax for the above slab is proposed to be 10 percent of the amount by which the total income exceeds 1, 60,000. Meaning, if your income is 572,000/- then, the income tax would be 10% of (Rs 572,000-Rs 160,000). Although for individuals who were earlier earning between Rs 160,000 and Rs 300,000 this does not bring about any change, it brings great cheer for individuals earning between Rs 300,000 and Rs 500,000 as they straight away save 10% of any income that exceeds Rs 300,000, but is lesser than Rs 500,000. Today they have to pay 20% on this amount!

For individuals who are today earning above Rs 500,000, this would bring even more cheer as they save a flat Rs 20,000,plus 20% of any amount above Rs 500,000 and lesser than Rs 1,000,000!

Example: Ram's income today is Rs 7 00,000

Income tax as per present rates = Rs 118,450 (excluding surcharges and any cess)

Income if new code comes into effect = Rs 54,000, a saving of Rs 61000

Slab 3: Income is between Rs 10,00,001 and Rs 25,00,000

The code proposes the income tax for this slab to be Rs 84,000 (10% of 840,000) plus 20% of any amount above Rs 10,00,001 but lesser than Rs 25,00,000. This would also bring about happy tidings for people who are currently earning above Rs 1,000,000 as they save around Rs 100,000 plus 10 per cent of any income which exceeds 10,00,000.

Slab 4: Income exceeds Rs 25,00,000

The code proposes the income tax for this slab to be Rs 384,000 plus 30% of any amount exceeding Rs 25,00,000. People currently earning above 25,00,000 would expect savings of over 40% of their current tax liabilities.

Away with 'assessment and previous year'

The new code has proposed to do away with the concept of using 'previous year' to denote the year in which you earned the money and 'assessment year' the year in which you pay the self assessment tax and file your return.

The new proposal is to use the simpler terminology of Financial Year (FY). For example if you earned income in FY09-10 then, your pay advance tax in FY09-10 and any balance tax and returns in FY10-11.

Source of income defined:

The income is proposed to be bifurcated into 'special sources' and ordinary sources. The special sources include items like lotteries, games and non residents etc which will be charged on the basis of a rate schedule.

Thus while calculating the total income we will have to add total income from ordinary sources and total income from special sources.

Source based versus Residence based taxation:

Source based taxation is a process in which the income tax is calculated on the basis of the source of income whereas residence based taxation calculates income on the basis that individuals are taxable in the country or tax jurisdiction in which they are residing.

The debate has been for long on which methodology to use. The new code proposes to use residence based taxation for residents and source based taxation for non-residents.

It states 'a resident in India will be liable to tax on his worldwide income and a non-resident will be liable to tax in India only in respect of receipts in India'.

What this means is that if you have been out of India for more than 183 days you would be treated as a non-resident and you need not pay tax on income which has already been taxed in the country where you get the income from and also if it's not taxed there.

But, in case of residents the income which has not been taxed in another country will be taxed in India upon repatriation.

Capital gains

The new code proposes two important ideas.

The concept of long term and short-term defined by the period of holding of a capital asset will be removed.

Instead, for any capital asset which is transferred, to get a gain, anytime after one year from the end of the financial year in which it was acquired, the cost of acquisition and cost of improvement wil be adjusted on the basis of cost inflation index to reduce the inflationary gains?

The base date for calculation of cost of acquisition of a capital asset has been proposed to be shifted from 01-01-1981 to 01-04-2000. This would be a big disadvantage to people who had brought the assets very long ago.

The reason is that you would have brought it for very low prices but the capital gains will be calculated based on the price of the asset on 01-04-2000.

The above discussions are some of the very visible proposed changes in the Direct Taxes Code which would affect individuals. The idea behind the whole exercise is for the public to give their feedback regarding their views before the discussion document is presented to the parliament.

If you have any comments/suggestions you could mail to the IT department at: directtaxescode-rev@nic.in and hopefully the finance minister might consider it important to be a part of the new code!

- BankBazaar.com

Mirage In The Markets

There are 2 opposing sentiments that need to play out in world stock markets in general. The bulls believe that the world is returning to ‘normal’, while the bears believe that the world can still come to an end. At the moment, the bulls have an upper hand, but I have certain behavioural indicators that suggest that the bears may have a point. You can’t increase global Money Supply by an estimated 25 per cent, take the Fiscal Deficit to 12-15 per cent in major countries, and not increase inflationary expectations. Ignore this at your own peril….

So, then what explains the rally so far? Call it the return of ‘animal spirits’, people who have just got tired of waiting, and who don’t know what to do with their freshly-earned cash; maybe the stimulus money waiting to go somewhere. Or just late-stage momentum…? The return of the stock market ‘tipster services’, the revival of brokerages and the quick resurgence of day-traders tells me that this is a late-stage bull rally already, with little change by way of fundamentals. That would suggest that market (volatility) risk has gone up dramatically.

Let us look at how fundamentals have changed since 2007. First, the Asian savings glut. China is no longer buying US Treasuries, and the US Current Account Deficit has halved (to $400 bn). So the supply of limitless liquidity with low inflationary expectations has gone; it has been temporarily replaced by the promise of Government Fiscal Stimulus, which will fuel inflationary expectations if they actually happen. Governments are already working hard at promising Bond markets that these funds will never be let loose, otherwise the world is headed for a 1971-like inflationary shock. Look at what the G8 just said; no further talk about pumping cash, but some pious statements about how to pull them back in, once things return to normal.

If China is no longer there to drive down Treasury yields, who subscribes to those US Bonds at the margin? The US citizen now has a 5 per cent savings rate, but he expects inflation at 3-5 per cent, which means T-bills go at 7 per cent. That is above the historical average, in the middle of the worst recession since 1929. Hardly the stuff that promises recovery…!!! More important, if the supply of T-bills continue, it could fuel inflationary expectations, driving the US into a hyperinflation loop with a Dollar collapse.

The DXY Index is falling, despite a halving of the Current Account Deficit. That suggests capital flight, and we can see where the money is going: to commodities (like oil) and Emerging Markets, especially those who are seen as ‘commodity currencies’ like Brazil and now Russia. India, one of the beneficiaries of low oil prices, could see one of the false rallies, as oil prices go back up, the Current Account Deficit balloons and its invisibles account sees a dip because of the weakening purchasing power of the Dollar (which reduces IT flows).

A key threat to the Dollar’s destiny is the Bond market’s view on the $12 tn (83 per cent of GDP) that the US Fed has committed. The Fed now has to convince the Bond markets that this money will never be released, else there will be a run on the Dollar. This is the key theme running through currency markets just now. Contrarians are punting on the possibility of the Fed actually raising rates just now (even with 9+ per cent unemployment) to get back some Dollar strength. If the dam breaks on the other side, it may be impossible to retrieve Dollar credibility. Will the Fed do it? Let us look at what happens if it doesn’t. You will have a clear bubble in oil, even with falling demand. This will anyway fuel inflation and affect growth, puncturing the famous India story, for example. It will also push global stagflation, hardly the stuff recoveries are made up of.

Why should you worry about Dollar weakness? A desperate Euro, with 9.6 per cent unemployment and 2 sovereign defaults within its community, is trading at a 2-Sigma high (it has been higher only 5 per cent of the last 5 years). Does this look normal?

The traditional formula of increasing Money Supply only works till people feel that money is valuable. At some inflexion point, if people lose that faith, you become a Zimbabwe. This is called Rational Expectations Theory, and is the exception to the Keynesian “pay money to dig holes” prescription for coming out of a recession.

There is a point at which you need to focus on building the credibility of the currency, like Paul Volcker did when he triggered the 1987 recession with 14 per cent government bond rates, but clearly stood on the side of a ‘strong Dollar’. This credibility was subsequently destroyed by Greenspan. Maybe the cycle has to repeat itself….

So is there a genuine demand-led recovery anywhere in the world, which needs to be discounted in its stock markets? I can’t see it anywhere, despite the specious media arguments that ‘we are an exception’. This is no different from the ‘India Shining’, ‘India Decoupled’ and ‘India Great’ arguments, where a cricketing victory has been seen as indirect evidence of future Indian greatness, justifying a bull market.

The property market is even more ridiculous, mainly because more people have property than have shares. This last property boom-bust was larger, more widespread and deeper than ever before. Why would the cycle be shorter than ever before? It normally takes 3 years to run out inventory; this time, if anything, it should take longer because of weaker incomes and lesser availability of good credit.

This bull market is more the creation of the mutual fund industry and the media than anything else I have ever seen. If you can trade your way out of this shallow and artificial ‘bull run’, go for it. If you have the courage and the skills, get in with a trader’s eye, and ride a big spike in stock prices that could leave you richer but unhappier than before. A trader’s life is not a good one, because you have to learn to live with losses.

Most retail investors lose money to the markets. Japan, Korea and Taiwan, even China have seen huge economic growth, but volatility in the stock markets has never created wealth for its citizens, just as Las Vegas has never made the gamblers rich. Long-term wealth in stock markets is created for the retail investor only by good companies that grow without volatility, like the “FERA companies” created wealth for our parents through a generation of bonuses and dividend payouts. Remember Colgate and HLL? The difference is made by Corporate Governance and a culture of sharing with minority investors, not the absolute amount of profits generated. This is missing in Asian companies, but thankfully, we have some honourable Indian exceptions (like the Tatas, Infosys and Bharti).

Warren Buffet has fed the notion that long-term investors in general make money. This is not true, unless you have the skills and perspicacity of Buffet. With the exception of GE, no company has lasted long enough to make sustainable money for its investors. Yes, markets may appreciate over the long term, so investors who invest in Index Funds might make money, but not buy-and-sleep investors who invest in cos.

If you think this rally is for real, you are making a mistake and should get out as soon as possible. If you lost money in 2007-08, then history is not on your side….

- ValueResearchOnLine

Calculation of Financial Ratios

EBITDA

Profit/(loss) before depreciation, amortisation and write-downs

EBITDA, % of net sales

EBITDA x 100
Net sales

Operating profit/(loss) before goodwill amortisation (EBITA)

Operating profit/(loss) before goodwill amortisation

Operating profit/(loss) before goodwill amortisation (EBITA), % of net sales

Operating profit/(loss) before goodwill amortisation x 100
Net sales

Profit/ (loss) before taxes, % of net sales

Profit /(loss) before taxes ² x 100
Net sales

Return on equity, % (ROE)

Profit/(loss) for the period ³ x 100
Equity (on average)⁴

Return on capital employed, % (ROCE)

Profit/(loss) before taxes ⁵ +interest charges and other financial costs x 100
Balance sheet total less interest-free debt (on average)

Return on net assets, % (RONA)

Operating profit/loss + goodwill amortisation_______________________________________x 100
Fixed assets⁶ – less goodwill + inventory + short-term receivables less short-term interest-free debt (on average)

Equity ratio, %

Equity ⁷ _____________________________________ x 100
Balance sheet total less received advance payments

Capital expenditure

The acquisition cost of tangible and intangible assets and investments belonging to the fixed assets including receivables from granted loans counted as fixed assets (not including corporate acquisitions)

Capital expenditure, % of net sales

Capital expenditure x 100
Capital expenditure

Capital expenditure

R&D costs x 100
Net sales

Gearing, %

Interest-bearing debt less cash and cash equivalents x 100
Equity⁸

Interest-bearing net debts

Interest-bearing debt less cash and cash equivalents
² FAS: Profit/(loss) before extraordinary items
³ FAS: Profit/(loss) before extraordinary items less taxes
⁴ FAS: Equity + minority interest (on average)
⁵ FAS: Profit/(loss) before extraordinary items
⁶ IFRS: Non-current assets less deferred tax assets
⁷ FAS: Equity + minority interest8 FAS: Equity + minority interest

- Salcomp

Free Cash Flow: Free, But Not Always Easy

The best things in life are free, and the same holds true for cash flow. Smart investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business - all important undertakings from an investor's perspective. However, while free cash flow is a great gauge of corporate health, it does have its limits and is not immune to accounting trickery.

What Is Free Cash Flow?
By establishing how much cash a company has after paying its bills for ongoing activities and growth, FCF is a measure that aims to cut through the arbitrariness and "guesstimations" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense in the calculation of income or turned into an asset on the balance sheet, free cash flow tracks the money.

To calculate FCF, make a beeline for the company's cash flow statement and balance sheet. There you will find the item cash flow from operations (also referred to as "operating cash"). From this number subtract estimated capital expenditure required for current operations:

Cash Flow From Operations (Operating Cash) - Capital Expenditure --------------------------- = Free Cash Flow

To do it another way, grab the income statement and balance sheet. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working capital, which is done by subtracting current liabilities from current assets. Then subtract capital expenditure, or spending on plants and equipment:

Net income + Depreciation/Amortization - Change in Working Capital - Capital Expenditure ---------------------------- = Free Cash Flow

It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment, however, is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high up-front costs, which may eat into earnings now but have the potential to pay off later.

What Does Free Cash Flow Indicate?
Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF - due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distributions or debt elimination - can reward investors tomorrow. That is why many in the investment community cherish FCF as a measure of value. When a firm's share price is low and free cash flow is on the rise, the odds are good that earnings and share value will soon be on the up.

By contrast, shrinking FCF signals trouble ahead. In the absence of decent free cash flow, companies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business.

Is Free Cash Flow Foolproof?
Although it provides a wealth of valuable information that investors really appreciate, FCF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand.

Without a regulatory standard for determining FCF, investors often disagree on exactly which items should and should not be treated as capital expenditures. Investors must therefore keep an eye on companies with high levels of FCF to see if these companies are under-reporting capital expenditure and R&D. Companies can also temporarily boost FCF by stretching out their payments, tightening payment collection policies and depleting inventories. These activities diminish current liabilities and changes to working capital. But the impacts are likely to be temporary.

The Trick of Hiding Receivables
Let's look at yet another example of FCF tomfoolery, which involves specious calculations of the current accounts receivable. When a company reports revenue, it records an account receivable, which represents cash that is yet to be received. The revenues then increase net income and cash from operations, but that increase is typically offset by an increase in current accounts receivable, which are then subtracted from cash from operations. When companies record their revenues as such, the net impact on cash from operations and free cash flow should be zero since no cash has been received.

What happens when a company decides to record the revenue, even though the cash will not be received within a year? This question is inspired by telecom equipment maker Nortel Networks' year 2000 financial statements. The receivable for a delayed cash settlement is therefore "non-current" and can get buried in another category like "other investments". Revenue then is still recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy a big but unjustified boost. Tricks like this one can be hard to catch.

Conclusion
Alas, finding an all-purpose tool for testing company fundamentals still proves elusive. Like all performance metrics, FCF has its limits. On the other hand, provided that investors keep their guard up, free cash flow is a very good place to start hunting.

- Investopedia

Taxing Times

If you claim to be a smart investor, then you cannot view your investment solely on the basis of the return it can generate. You have to simultaneously check out the tax implications of that investment.

Is it an avenue that will help you save tax like the Public Provident Fund (PPF) or an Equity Linked Savings Scheme (ELSS)? Would you have to pay tax on the interest earned (fixed deposit) or is it tax free (PPF)? Would dividends be taxed or not? Would you be taxed if you made a profit on a sale (stocks, mutual funds or real estate)?

An investment made may seem fantastic, like a fixed deposit with an absolutely great interest rate. But since the interest earned is taxed, the yield drops. And, if you fall in the highest tax bracket, that is going to be your tax impact. All of a sudden, the investment sucks!

What we have done here is look at the tax implication on all investments made in mutual funds.

Where the tax angle is concerned, there are just two categories to consider - equity and debt. This should avoid any sort of confusion. Schemes that invest 65 per cent or more of their entire corpus in domestic equity (shares of companies listed in stock exchanges in India) are termed as equity schemes. The rest fall into the debt category.

Before we move on, let's just talk of one set of funds called the asset allocation funds. These funds have the mandate to be totally flexible in their asset allocation. They can move all their assets into equity or totally exit it, all at the discretion of the fund manager or a mathematically computed programme that takes the call. This makes their tax computation a bit difficult. Hence it is only at the end of the year that one gets to know where these funds have invested and accordingly determine their tax status.

Another area where we do have some ambiguity is in the case of arbitrage funds, which are categorized as "Hybrid: Arbitrage". These funds take advantage of a price mismatch between the cash market and the futures market. But, the asset allocation may also move between equity and debt as in the case of UTI SPrEAD. The average debt allocation has been in the vicinity of 68 per cent while equity has been around 6 per cent (March 2008 - August 2008). As on August 31, 2008, UTI SPrEAD had an equity allocation of 10.56 per cent, while the corresponding figures for JM Arbitrage Advantage and SBI Arbitrage Opportunities were 71.48 per cent and 71 per cent, respectively. JP Morgan India Alpha states in its Offer Document that this arbitrage fund should be treated as a debt fund.

GETTING A FIX ON CAPITAL GAINS
When an investor sells an asset and makes a profit, it is termed as a capital gain (capital loss should the reverse hold). This asset could be anything - home, land, stocks, mutual funds, fixed return instruments like fixed deposits, bonds and debentures, and even gold. The tax levied on this profit is called the capital gains tax.

Depending on how long you held the asset, it is broken up into Long Term Capital Gains (LTCG) and Short Term Capital Gains (STCG).

Where all mutual funds are concerned, LTCG comes into play if you sell your units after 12 months of holding. But, if you sell them within a year of buying, then STCG is applicable.

Equity
Where all equity mutual funds are concerned, the deal is identical for an individual or corporate.

The LTCG is not taxed. That's right, it is nil. So if you sell your shares or units of your equity fund after a holding period of a year, you pay absolutely no tax on the gain.But if you sell it before a year, then the STCG tax is 16.99 per cent. This includes the capital gains tax rate as well as the surcharge and cess (15%+10%+3%).

Debt
If you sell your debt fund before a year of holding, STCG comes into play. If you sell it after a year, then LTCG is relevant.

The good aspect with LTCG is that the income tax authorities give you the option to include the benefit of indexation. Indexation is the process by which inflation is taken into account when doing the tax calculation. This is excellent because it reduces the amount of capital gains and consequently the amount you end up paying as tax.

ARE DIVIDENDS TAXED?
There seems to be a lot of confusion concerning the Dividend Distribution Tax (DDT). It is a tax imposed only on the Asset Management Company (AMC) and not on the investor. However, the AMC will deduct the dividend tax from the money that will eventually go to the investors. So it's the investor that loses out in the end, not the AMC.

MAKING THE RIGHT CHOICE
Let's look at a basic dilemma facing investors: Is a growth option more viable or a dividend one? After looking at the tax implications, which one is the better option?

To answer this query, we will have to assume two scenarios, one where the investment is done for a period of less than 12 months, and the other for more than a year. This will enable us to better understand the short- and long-term capital gains impact.

Types of Equity Funds
Diversified: Funds that invest in Indian equity across sectors and market cap.
ELSS: Tax-saving funds that have a 3-year mandatory lock-in period.
Index: Such portfolios replicate the relevant index constituents. It also includes Exchange Traded Funds (ETFs).
Sector: Funds with a focus on a particular sector - FMCG, banking, auto, media, healthcare & pharma, technology, power.
Thematic: Focus on a theme like infrastructure.
Hybrid: Only the equity oriented ones.
Fund of Funds: Those funds that invest in the schemes of the other funds.

Types of Debt Funds
Medium Term: The maturity profile of the portfolio is more than 3 years.
Short Term: The maturity profile ranges from 1-3 years .
Ultra Short Term: Also termed as liquid funds, the maturity profile is less than 1 year.
Liquid Plus: 30% - 50% of the assets are in debt securities of maturity greater than 1 year, the balance maturity is less than a year.
Gilt: Short Term: The funds invest in government securities (G-Secs) with a maturity profile of less than 3 years.
Gilt: Medium-Long Term: G-Secs with a maturity profile greater than 3 years.
Floating Rate Short Term: Portfolio with floating rate debt instruments tilted towards short-term maturity.
Floating Rate Long Term: Portfolio with floating rate debt instruments tilted towards long-term maturity.
Hybrid: Those with an equity allocation of less than 65%.
Gold ETFs: Exchange Traded Funds take exposure to physical gold.
MIPs: With a max. equity exposure of 15%, their portfolio consists of bonds, CP, CDs, G-Secs and T-Bills.
International Funds: They invest in foreign equity, not domestic.
Fund of Funds: Those that invest in funds abroad do not fulfill the criteria of investing in domestic equity. FMPs:Fixed Maturity Plans are close-ended income schemes that invest in debt and money market instruments maturing in line with the tenure of the scheme.

IS AN STP WORTH IT?
In a Systematic Transfer Plan (STP), a fixed amount is switched from one scheme to another at regular intervals. In effect, it works out to be a combination of a Systematic Withdrawal Plan (SWP) and a Systematic Investment Plan (SIP).

A SWP is one where the mutual fund allows you to redeem units at regular intervals. A SIP, on the other hand, allows you to buy units periodically. Both the dates, and the amount to be withdrawn or invested, will be predetermined.

So how would a STP work? Let's say an investor puts a lump sum amount in a debt scheme. He then instructs the mutual fund to transfer a small amount from this debt scheme to an equity scheme every single month at a particular date. So it is a SWP from the debt fund but a SIP into the equity one.

Since the STP works on the principle of redemption and fresh investment, the tax implication would be same as capital gains (short-term or long-term) on the redemption of equity or debt funds.

WHAT IS THE STT?
The Securities Transaction Tax (STT) is levied on the value of a transaction. So when you redeem your units in an equity fund (not debt) or switch them to another scheme, STT of 0.25 per cent will be applicable.

- ValueResearch

Declaration, Ex-dividend And Record Date Defined

Have the workings of dividends and dividend distributions mystified you too? Chances are it's not the concept of dividends that confuses you; the ex-dividend date and date of record are the tricky factors. In this article we'll sort through the dividend payment process and explain on what date the buyer of the stock gets to keep the dividend.

Before we explain how it all works, let's go over some of the basics to ensure we have the proper foundation to understand the more complex issues. Some investment terms are thrown around more often than Frisbees on a hot summer day, so it's important that we define exactly what we're talking about.

Different Types of Dividends
The decision to distribute a dividend is made by a company's board of directors. There is nothing requiring a company to pay a dividend, even if the company has paid dividends in the past. However, many investors view a steady dividend history as an important indicator of a good investment, so most companies are reluctant to reduce or stop their dividend payments. (For more information on buying dividend paying stocks, see the articles How Dividends Work for Investors and The Importance of Dividends.)

Dividends can be paid in various different forms, but there are two major categories: cash and stock. The most popular are cash dividends. This is money paid to stockholders, normally out of the corporation's current earnings or accumulated profits.

For example, suppose you own 100 shares of Cory's Brewing Company (ticker: CBC). Cory has made record sales this year thanks to an unusually high demand for his unique peach flavored beer. The company therefore decides to share some of this good fortune with the stockholders and declares a dividend of $0.10 per share. This means that you will receive a check from Cory's Brewing Company for $10.00 ($0.10*100). In practice, companies that pay dividends usually do so on a regular basis of four times a year. A one-time dividend such as the one we just described is referred to as an extra dividend.

The stock dividend, the second most common dividend paying method, pays additional shares rather than cash. Suppose that Cory's Brewing Company wishes to issue a dividend but doesn't have the necessary cash available to pay everyone. He does, however, have enough Treasury stock to meet the requirements of the dividend payout. So instead of paying cash, Cory decides to issue a dividend of 0.05 new shares of CBC for every existing one. This means that you will receive five shares of CBC for every 100 shares that you own. If any fractional shares are left over, the dividend is paid as cash (because stocks can't trade fractionally).

Another type of dividend is the property dividend, but it is used rarely. This type of allocation is a physical transfer of a tangible asset from the company to the investors. For instance, if Cory's Brewing Company was still insistent on paying out dividends but didn't have enough Treasury stock or enough money to pay out all investors, the company could look for something physical (property) to distribute. In this case, Cory might decide that his unique peach beer would be the best substitute, so he could distribute a couple of six-packs to all the shareholders.

The Important Dates of a Dividend
There are four major dates in the process of a company paying dividends:

• Declaration date– This is the date on which the board of directors announces to shareholders and the market as a whole that the company will pay a dividend.
• Ex-date or Ex-dividend date– On (or after) this date the security trades without its dividend. If you buy a dividend paying stock one day before the ex-dividend you will still get the dividend, but if you buy on the ex-dividend date, you won't get the dividend. Conversely, if you want to sell a stock and still receive a dividend that has been declared you need to sell on (or after) the ex-dividend day. The ex-date is the second business day before the date of record.
• Date of record– This is the date on which the company looks at its records to see who the shareholders of the company are. An investor must be listed as a holder of record to ensure the right of a dividend payout.
• Date of payment (payable date) – This is the date the company mails out the dividend to the holder of record. This date is generally a week or more after the date of record so that the company has sufficient time to ensure that it accurately pays all those who are entitled.

Why All These Dates?
Ex-dividend dates are used to make sure dividend checks go to the right people. In today's market, settlement of stocks is a T+3 process, which means that when you buy a stock, it takes three days from the transaction date (T) for the change to be entered into the company's record books.

As mentioned, if you are not in the company's record books on the date of record, you won't receive the dividend payment. To ensure that you are in the record books, you need to buy the stock at least three business days before the date of record, which also happens to be the day before the ex-dividend date.



As you can see by the diagram above, if you buy on the ex-dividend date (Tuesday), which is only two business days before the date of record, you will not receive the dividend because your name will not appear in the company's record books until Friday. If you want to buy the stock and receive the dividend, you need to buy it on Monday. (When the stock is trading with the dividend the term cum dividend is used). But, if you want to sell the stock and still receive the dividend, you need to sell on or after Tuesday the 6th.

*Note: Different rules apply if the dividend is 25% or greater of the value of the security. In this case, the Financial Industry Regulatory Authority (FINRA) indicates that the ex-date is the first business day following the payable date. For further details on dividend issues, search FINRA's website.

A Money Machine?
Now that we understand that a dividend can be received by purchasing the stock before the ex-date, can we make more money? Nope, it's not that easy. Remember, everybody knows when the dividend is going to be paid, and the market sees the dividend payout as a time when the company is giving out a part of its profits (reducing its cash). So the price of the stock will drop approximately by the amount of the dividend on the ex-dividend date. The word "approximately" is crucial here. Due to tax considerations and other happenings in the market, the actual drop in price may be slightly different. In any case, the point is that you can't make free profits on the ex-dividend date.

Conclusion
The reasons for and effects of all these dates are by no means easy to grasp. It's important to clear up any confusion between ex-dividend and record dates. But always keep in mind that when you're investing in a dividend paying stock, it's more crucial to consider the quality of the company than the date on which you buy in.

- Investopedia

Winning The Mixed Doubles

As the number of double-income families is increasing, so is the awareness of personal finance issues. It’s not just about having a joint bank account anymore. Mumbai-based couple Sebanti, 38, and Prithwijit Maitra, 41, feel that planning their financial tomorrow together plays a major role in strengthening their relationship which began 15 years ago. But more important is their decision to not leave out each other from the planning process. Be it saving for the education and marriage expenses of their two daughters or making a strategy to become salary-free by the time they retire, they plan together.

Homemaker Dolon Champa Sircar, 36, and Niloy Sircar, 43, who is a project manager living in Kolkata, also want to make the journey to a secure financial future together. For many, planning finances and goals with their spouse is one of the ‘don’ts’ picked up from parents and grandparents. But then there are others who make an extra effort to manage their money together because they understand the benefits of doing so.

Joint decision making apart, it is also critical to share financial information with the spouse. Kartik Varma, co-founder, iTrust Financial Advisors, says, “In the coming decade, many more households will start focusing on articulating their [financial] goals and discussing them openly within the family.” Understanding why this is important and what to do to make this work will help make your family’s future hassle-free.

Why plan together?

Being prepared for potential emergencies. In case of an unfortunate event such as death of one spouse, the surviving spouse would suffer if he/she has no knowledge of the family’s finances and asset status. Similarly, if there is a medical emergency, the couple needs to know about each other’s health covers and should have access to emergency funds.

Chennai-based lawyer K.V. Subha mentions the case of Shankari (name changed) from the same city, who lost her husband in an accident, to show why this is important. Shankari was not aware of her husband’s investments and had to ­arrange Rs 12 lakh for his emergency hospitalisation expenses before his demise. She mortgaged the house and her jewels to pay for the bills. Later, while going through her husband’s personal belongings, Shankari found a health insurance policy, which should have been renewed a month before the incident.

***
Priya 37 & Bala Venkat 41 Chennai
The Venkat couple shares their money responsibilities. Priya manages daily expenses and their investment portfolio.
"But we know what is happening in each other’s world. He tells me where he has invested and how much."
***

Lovaii Navlakhi, managing director and chief financial planner, International Money Matters, Bangalore, recalls another case in which a retired client had filed and documented all his papers diligently and taken good care of his cash flow as well. But, he had not involved his wife in the money management. She had difficulty taking over the responsibility after he died suddenly.

Reasons enough to make sure your spouse knows the what, when and how of your investments (see Ready Reckoner).

Two heads are better than one. Taking joint decisions helps not just in emergencies, but also in better understanding the family’s needs and getting a firm hold on financial goals. In the process, the couple also gets a holistic view of the family’s finances, from day-to-day needs to long-term goals. Pointing the need to think ahead, Dolon says, “Our joint discussions help us understand whether we can sustain the outflow towards investments.”

A joint venture ensures that investments are not overweight on one spouse. Systematically made joint plans also help in fair distribution of wealth among family members.

If a couple applies for a home loan jointly, they become eligible for a bigger loan. Not to forget the tax advantages here. Says Navlakhi, “If a property is held jointly and the home loan is also taken jointly, for example, then both spouses can claim interest deduction.”

If holding investments jointly, opt for the ‘either or survivor’ option in the application forms as this helps if either spouse is not around. With this option, any spouse can transact on that account without having to get signatures of all the account holders.

“Power of attorney can also be given so that investments can be managed smoothly,” says Navlakhi.

Playing a mixed-doubles game can also be a great way to save on time, especially for working couples. Says Sebanti: “Due to my husband’s time constraints, sometimes I do the initial research on various investment products. But the final decision of where to invest is taken jointly.”

You could also use the services of a financial planner to make things easier.

How to play the team game

1. Discuss financial goals at regular intervals. A couple needs to jointly give direction to their family’s financial goals, whether it is saving for their children’s education or marriage, taking care of parents or their own retirement plans. Varma says, “Discussions need to happen frequently, at least once a year. It helps to keep the goals in focus and move towards them by planning expenses accordingly.”

The Maitras review their investment plans every three months. Says Sebanti: “This helps us decide whether we need to step up savings and how much to put aside for our future requirements. We are constantly looking at various investment options that will help us maintain our current lifestyle at the time of retirement after factoring in inflation.”

Bangalore-based couple of Deepti, 25, and Sandeep Balani, 30, revisit their investment goals at least once in six months. “This helps us invest in any new schemes or options that come up in the market,” says Sandeep.

2. Share money responsibilities. Many couples divide money roles among themselves, as do Chennai-based Priya, 37, and Bala Venkat, 41. While Priya takes care of the daily planning, Venkat handles the investment portfolios. “But we know what is happening in each other’s world. He gives me an idea of where he has invested and how much,” says Priya.

3. Understand the money flow. Discuss your family budget so both know where the money is coming from and where it is going. This is critical to keep all goals, however distant they might be in the future, in sight. Doing this can go a long way in regulating the money flow towards different directions. For example, retirement planning should not get ignored in favour of children’s education, nor should holidays gobble up money that could have gone towards funding your children’s higher education.

4. Know your existing investments. The couple needs to know where the money has been invested and have a fair idea about existing assets and liabilities.
Make a Will and keep updating it. If you do not have a Will, make one at the earliest, especially if you are married. Doing this makes any kind of transfer of assets clear and trouble-free. Otherwise, the process can consume a lot of time, effort and money. Nikunj Kedia, director, PARK Financial Advisors, says, “It is important that the family members know the details of the attorney who is executing the Will. Specific details of the Will need not be disclosed if not required.”

Another simple step is to nominate beneficiaries in all investments. For instance, most of the Sircar couple’s investments are in joint names with their daughter as the nominee.

***
Dolon Champa 36 & Niloy Sircar 43 KolkKata
The Sircars regularly talk about their money matters to get an overall view of their finances, be it day-to-day expenses or long-term investments.
“Our joint discussions help us understand whether we can sustain the regular outflow toward investment."
***

5. Audit your documents regularly. Regularly review the list of all investments, including insurance policies, bank accounts, bank lockers, demat accounts, fixed accounts, provident fund accounts and property papers, and make updates. List the details of the liabilities and assets. Review loan documents, whether personal, car or home, and other forms of repayments. You could also list out details of major outflows like your children’s education. Priya says, “We go through our paper work every six months to make sure that everything is in order and follow up on premiums that need to be paid.”

Such an exercise is also a method of reducing redundancies like inoperative bank accounts that need to be closed. You can also review your current investment products, deploy underperforming investments elsewhere and buy any new products that come in the market.

***
Sebanti 38 & Prithwijit Maitra 41 Mumbai
The Maitras not only plan their investments together and share the related work, but also review them every three months.
"This helps us take a decision on whether we need to step up savings and how much to put aside for our future requirements."
***

6. Know where the documents are kept. An insurance policy or investment has no meaning if your family cannot access it at the time of need (see Documents To Keep). Ensure that your spouse knows where all the important documents are kept. You can create an online or a physical document that has the essential details of insurance policies and other investments. It should also mention where these documents are kept. Add contact details of the financial advisor or chartered accountant who may be handling your transactions. This document must be easily accessible. The actual documents can be stashed away in a safe, if needed. You can also store scanned copies of important documents on your computer. This makes for additional flexibility and ease of access.

Sandeep, for example, keeps his investment and insurance papers and also print-outs of online documents in a single file. “I make two photocopies. Deepti keeps one copy and my parents the other. The two copies are necessarily at different locations,” he says. Sandeep keeps this information with himself also.

Online tracking of investment portfolios is another option. Says Kedia: “There are websites that let you maintain a comprehensive view of your entire portfolio. Details of insurance policies can also be updated on these websites. Passwords of such sites should be documented in a secure manner and kept separately, and should be accessible.”

7. Disclose all important and material facts. Seems obvious, but doesn’t happen always. Be it income details, investments, signatures made on important documents, ancestral property or any kind of financial transaction, it should be with the consent or knowledge of your spouse. A spouse may suffer if he/she is not aware of any deal.

Making your life partner a partner in your money life doesn’t take much, but its benefits are many and long-lasting.

Source - OutlookMoney

Ease of settlement

Life insurance policy is a legal contract between the insurance company and the insured, where the former agrees to pay a pre-defined sum to the nominee on the death of the insured. However, making a claim on a life cover is not necessarily the happiest of tasks, and for women, it's especially daunting. Even for a survival claim, particularly on moneyback policies, though the amount reaches the beneficiary automatically, at times the procedure is cumbersome because of the documentation required.

Women often face problems in a survival claim because they tend to change their names after marriage but fail to inform the insurer. So the benefits dispatched by the insurance company are not cleared by banks because the policy document is still in the maiden name. Subsequently, the policyholder is required to make a fresh claim and provide the requisite documents.

In case of the death of the insured, a basic procedure needs to be followed to make a claim and get the proceeds. As a first step, the nominee needs to submit a claim form, which varies across insurers. The form must be complete and the details demanded must be provided. The nominee also needs to submit the original policy document, attested copies of the death certificate, and if it is a medical or legal case, the requisite medical and policy reports. The nominee also has to furnish the proof of his own identity before the claim can be settled.

Unlike policy servicing, which is handled by agents, claims are settled directly by the insurance company once it finds the documentation satisfactory. So women should be wary of any person who tries to facilitate or help in the claims process.

After the necessary forms and documents are submitted, the insurer takes between 10 days and two weeks to verify them and can ask for more documentation, if needed. The Insurance Regulatory and Development Authority (Irda) has stipulated that claims be settled within 30 days of the receipt of the relevant documents. However, the insurer can ask for clarifications or supporting documents if the submitted documents are not satisfactory. For instance, in case of death due to medical reasons, the insurer can seek details on the insured's health and past medical history.

Even in cases where the insurer seeks additional details, the claim has to be settled within six months from the date of intimation of the claim. If the insurer fails to meet the deadline, he has to pay an interest on the sum assured. The nominee can also approach the ombudsman if the insurer fails to pay the claim on time.

Documents needed for a quick and error-free settlement of claim, the nominee needs to submit the following papers to the insurance company:

1. Policy document
2. A copy of death certificate.
3. A copy of photo identify proof of the claimant such as the passport, PAN card, election card or the driving licence.
4. A copy of proof of current residence in the name of the claimant such as the electricity bill, telephone bill, ration card, passport or election card.
5. A filled claim form, along with bank account details.
6. Insurers can demand more documentation if the death is after a prolonged illness and hospitalisation or required police intervention.

Source - MoneyToday

A Better Alternative?

No exams or competition. Just the freedom to expand his horizons. Non-traditional education may be just right for your child in his formative years

What To Do

• Verify the reputation of the school before admitting your child
• Support the child during his transition from alternative school to mainstream education
• Support him in pursuing his own interests
• If medicine or engineering is the goal, shift to a CBSE or ICSE school

Do you want your child to go through the same system of education that you did? Is it that you don’t quite agree with it, but don’t know whether there are other options available? Iif you are, then there are a number of options you can look at. For today, a number of non-traditional or alternative routes are available to your child. These include alternative schools and home-based learning. Here we concentrate on alternative schools. In India, some schools follow systems based on the Waldorf philosophy (of Rudolf Steiner) or on the teachings of Sri Aurobindo or J. Kishnamurthy.

Difference
"Alternative education is more child-centric, while the traditional system follows a more top-down approach,” says Pervin Malhotra, executive director, CareerGuidanceIndia, a career counselling firm.

Mainstream education focuses on completion of a fixed syllabus, exams, grading and promoting the child. In alternative education, children are given the freedom, space and time to explore topics of their interest. “It is not evaluation by comparing one human being with another, but objective assessment of the capacity of each child,” says K.T.S.V. Prasad, former director of Averbhav, an alternative school. A lot of importance is given to aspects such as appreciation of the fine arts and nature and the freedom of enquiry, which help in building a person as a whole. While children are given the freedom to pursue their own interests initially, they are taught language and mathematical skills as they grow up.

What Next?
The main question facing a parent is, “Will my child fit into the mainstream after his formative years?”

Alternative schools have different ways of dealing with this. Some may be only up to Class 5 or Class 8, after which the student is expected to get admission into a mainstream school. Other schools follow a different approach and take the onus of preparing their students for the board exams. The student has the options of the National Institute of Open Schooling (NIOS) and the International General Certificate of Secondary Education (IGCSE). Both have been recognised by Association of Indian Universities to be on a par with certificates awarded by other boards—ICSE, CBSE and state boards. the student passes NIOS or IGCSE with the required subjects, he is eligible for admission to mainstream schools in the country. He may then go on to pursue a career of his choice. Some schools also permit students to sit for senior secondary (Class 12 exams) under IGCSE and NIOS, after which they can get admission into any university.

Costs
Alternative education tends to be more expensive than mainstream education. That is not only because the student-teacher ratio is low, but also because the child is provided many facilities and also encouraged to take up extra-curricular activities such as sports and the performing arts. However, for schools run by charitable institutions, fees are on the lower side.

Fees can be between Rs 6,000 per annum and go up to Rs 35,000 per annum or more if it is a residential school. The expensive schools ask parents who can afford it to volunteer to pay higher fees so that students from a cross-section of society can be taken in. Chowgule stresses that no child is refused admission because of monetary reasons.

Viability
“Admitting a child into an alternative school does lead to his all-round development in the formative years,” says Shakun Chaudhury, Director, Ibambini pre-school, Gurgaon. However, before selecting an alternative school, one should check its background and also look at the alumni to see how many of them have managed to successfully integrate into mainstream education. “Ii tell parents to check if a school meets their criteria. One has to visit several schools before deciding what is best for one’s child,” says Chaudhury.


Students passing from alternative schools might find it a bit difficult to adjust to the mainstream. However, this varies from student to student. Students need the support of parents and teachers to make this transition. “Alternative schools have understood this and started preparing students for the pressures of the competitive world in the higher classes,” says Malhotra. “one feels that the child is cut out to join IITs or top medical colleges, one should shift him into a school under the CBSE, as the syllabus is more tuned to such competitive exams,” she adds.

So, if you do not want your child to be burdened by homework, tuitions and a heavy school bag from an early age, alternative education is the option to explore.

Source - outlookindia.com

Meet the Earnings Yield

One way to think about what you're paying for a company is to look at its price-to-earnings, or P/E, ratio. Another way is to calculate the inverse of that, which is its earnings yield.
Consider the example of Fryyndar and Ulf Scandinavian Pharmaceuticals (ticker: FANDU), whose motto is "Varsagod och svalj!" (That's Swedish for "Here, swallow this pill!") To calculate its P/E ratio, you simply divide the current stock price by the annual earnings per share (EPS). If its current annual EPS is $3 and the stock is trading for $111 per share, the P/E is $111 divided by $3, or 37.
To calculate Fryyndar and Ulf's earnings yield, just reverse the P/E ratio, dividing the annual EPS by the current stock price. $3 divided by $111 equals 0.027, or 2.7%. Compared to risk-free Treasury bond rates (of roughly 4.7% at the time of this writing), this doesn't appear to be a bargain. But remember: Whereas bond rates are usually fixed, earnings typically grow. Imagine that FANDU is expected to increase earnings 10% per year. If so, in 10 years EPS should grow to $7.78. Assuming we bought shares when they were at $111, the earnings yield for us has now become 7%, considerably better. ($7.78 divided by $111 is 0.07.)
It can be instructive to see how long it takes for the growing earnings yield to pass the current 30-year bond rate, which was recently around 4.7%. FANDU passes it within six years. (You can also compare it with shorter-duration bonds, and you can look up current bond rates on Yahoo!)
If your desired rate of return on your invested dollars is 15%, it will take FANDU 18 years to reach that target -- if earnings actually grow at the estimated pace, that is. Perhaps you can find another investment that will get you there more quickly. With riskier companies, you might look for them to pass your target rate sooner rather than later.
The earnings yield is just one of many investor tools. It shouldn't dictate any decision for you, but it can help you think more effectively about your expectations for investments.

Source - fool.com

How to read a balance sheet

A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements.

If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyse it and how to read it.

How the balance sheet works

The balance sheet is divided into two parts that, based on the following equation, must equal (or balance out) each other. The main formula behind balance sheets is:

assets = liabilities + shareholders' equity

This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings.

Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.

It is important to note, that a balance sheet is a snapshot of the company's financial position at a single point in time.

Know the types of assets

Current assets
Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes are: cash and cash equivalents, accounts receivable and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks.

Cash equivalents are very safe assets that can be are readily converted into cash such as US Treasuries. Accounts receivable consists of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit, which then are held in this account until they are paid off by the clients.

Lastly, inventory represents the raw materials, work-in-progress goods and the company's finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailers inventory typically consists of goods purchased from manufacturers and wholesalers.

Non-current assets
Non-current assets, are those assets that are not turned into cash easily, expected to be turned into cash within a year and/or have a life-span of over a year. They can refer to tangible assets such as machinery, computers, buildings and land.

Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated.

Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.

Learn the different liabilities

On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet.

Current liabilities are the company's liabilities which will come due, or must be paid, within one year. This is comprised of both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.

Shareholders' equity

Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder's equity account.

This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.

Read the Balance Sheet
Below is an example of a balance sheet:

Source: http://www.edgar-online.com

As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and the right side contains the company's liabilities and shareholders' equity. It also can be seen that this balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders' equity.

Another interesting aspect of the balance sheet is how it is organized. The assets and liabilities sections of the balance sheet are organised by how current the account is. So for the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short to long-term borrowings and other obligations.

Analyse the balance sheet with ratios

With a greater understanding of the balance sheet and how it is constructed, we can look now at some techniques used to analyze the information contained within the balance sheet. The main way this is done is through financial ratio analysis.

Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the company's financial condition along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.

The main types of ratios that use information from the balance sheet are financial strength ratios and activity ratios. Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged.

This can give investors an idea of how financially stable the company is and how the company finances itself. Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables). These ratios can provide insight into the operational efficiency of the company.

There are a wide range of individual financial ratios that investors use to learn more about a company.

Conclusion

The balance sheet, along with the income and cash flow statements, is an important tool for investors to gain insight into a company and its operations. The balance sheet is a snapshot at a single point in time of the company's accounts - covering its assets, liabilities and shareholders' equity.

The purpose of the balance sheet is to give users an idea of the company's financial position along with displaying what the company owns and owes. It is important that all investors know how to use, analyse and read one.

Source - Investopedia

Importance of Enterprise Value

Wall Street tracks market cap religiously while too often ignoring the more important enterprise value, which is the true economic value of a company at any given moment. Enterprise value is market cap plus long-term debt and minus cash and equivalents, for reasons explained today. This column originally ran December 4, 1997.

By Randy Befumo
February 21, 2002

A topic I want to cover is "enterprise value," which has confused quite a few Fools the country o'er.

Enterprise value is a measure of the actual economic value of a company at any given moment. Enterprise value measures what it would actually cost to purchase the entire company. Many investors use the current value of all of a company's outstanding shares as a proxy for its economic value. Known as market capitalization, the current market value of all of a company's shares is equal to the current number of outstanding shares multiplied by the current share price:

Market Capitalization = Number of Shares Out * Current Share Price

You can find the current share price almost anywhere, thanks to the wonder of 15-minute delayed and real-time quotes. Shares outstanding can be a little trickier, but truth be told I only use one source to find this number -- the latest quarterly earnings press release or SEC filing. Although the number appears in the quote feeds of a number of data providers, I have found that it often lags the latest reported quarter by a couple of weeks and seldom takes into account in timely fashion the shares issued to acquire another company.

Now, if market capitalization is the value of all of the outstanding shares, why use enterprise value at all? I mean, enterprise value only appears in a few business school textbooks that focus on cash-flow valuations. The rest of the investment media uses market capitalization. Well, let me let you in on a little secret. Wall Street is many things, but it is not thorough and it is not scientific. In fact, it is downright scary when you look hard enough and see that there is really no unified body of knowledge outside of the quite excellent Chartered Financial Analysts program (which has only about 40,000 graduates total ever) that analysts, market strategists, and pundits draw from. Carpentry (a quite noble profession) has a more rigorous set of intellectual standards.

Although market capitalization is the key component of the actual economic value of a company, it is hardly the only one. Using only market capitalization to value companies is kind of like using the down payment on a house as a proxy for how much a house is worth. The larger the mortgage on the house is, the more wrong you end up being. When a company carries long-term debt, which is essentially what a mortgage is, the company has pledged its own assets to borrow money. If someone were to acquire that company, she would also acquire responsibility for that debt. Much like the person who "assumes" a mortgage of $50,000 after paying $20,000 in equity for a home, a company that pays $20 million for the stock of a company with $50 million in debt has really paid $70 million for the entire company.

The simple fact is that debt matters. Now, many companies have an inconsequential amount of debt; however, there are plenty where the amount of debt that the company has is quite consequential. A controversial, Nobel prize winning economic theory called M&M (after two professors named Modigliani and Miller) proposed that the effective capital structure of a company was the market value of its equity plus its debt. The controversial part was when they went on to say that there is no optimum capital structure, meaning that every dollar of debt a company carried consumed a potential dollar of equity. Put another way, a company's value was a given. Whether it chose to recognize that value all in debt or equity was the company's choice -- there was no capital structure that resulted in a higher valuation without increasing earnings somehow.

Another very important factor to consider when analyzing a company is what it has in the bank. If a company has a hoard of cash or significant equity stakes in other publicly traded businesses, these are pretty easy to value and are obviously sources of liquidity for the company. Going back to our home example, say you bought a home for $70,000 -- $20,000 in cash and $50,000 in debt after assuming the mortgage. When you walked in the house, you found $20,000 in cash left by the previous owner. After putting this $20,000 in the bank, your effective purchase price becomes $50,000. Although you paid out $20,000 to the owner, you got it right back.

Because of the rather complicated rules of acquisition and corporate ownership, this somewhat ludicrous example happens all of the time in the business world. If a company has $20 million in cash in the bank, it is not like the outgoing Chairman can put it in his pocket as he leaves. That money belongs to the company -- and those who own the company. If someone is buying the company, that money really belongs to him or her. No one else can take it. As a result, when the old owners are paid off they are paid off with cash from the new owners -- leaving any cash in the company behind for the new owners to keep. Given that equity stakes in other publicly traded companies are really just as good as cash -- heck, maybe even better -- it makes sense to count this as part of the cash hoard for the purposes of determining what the actual economic price of a company is.

Given all of this, you can see that the real, economic purchase price of a company at any given moment is the value of the stock (the market capitalization), plus the debt that the company has taken on, minus any cash or investments it has on the books. This is what we call enterprise value. We use this instead of market capitalization because it is the actual economic purchase price of a company at any given moment. Enterprise value reflects the actual purchase price anyone acquiring a company would have to pay.

Enterprise Value = Market Capitalization + Long-term Debt - Cash & Investments

Why go to all of this trouble when some people argue that the value of the stock has already been adjusted for the debt and cash a company has? Because no matter how much the actual price of the stock changes, the debt and the cash do not go away. An acquirer still has to take on the debt and still gets to put the cash in the bank whether the company's stock is worth $1 billion or one dollar. Debt and cash are economic realities and must be factored into the purchase price an acquirer pays for a company. Enterprise value is not a valuation, meaning the theoretical price at which a company should trade, but a value, meaning the current, real price as definite as if stuck on with a pricing gun.

Randy Befumo is a former Fool writer currently working in the investment industry. This column first appeared on the Fool in 1997.

- fool.com

The avalanche effect of compounding interest

If you want to attain your weight-loss goal, eat less and exercise more. Well, it's no different when there is money involved. A parallel universal truth with regard to money is spend less, save more, for you to reach your ideal level of wealth.

The earlier you start saving for your rainy day (read retirement) the richer you will be when it finally arrives.

In this context, you need not be a whiz in your attempt to make yourself financially secure for the future. You simply need to be consistent in saving a portion of your money and let it compound over time.

The fascinating effect of compounding gathers up momentum over longer periods of time and becomes an avalanche of wealth.

How does compounding work?

When you save Rs 100 and get an annual interest of 10%, you will have Rs 110 at the end of one year. Due to compounding the next year you will get a 10% interest on Rs 110, which will then leave you with Rs 121. The next year, interest will be calculated on Rs 121 at 10% and so on. In time, these savings will grow exponentially.

There are certain number rules that have been evolved to figure out a quicker method for calculations, especially in finance. Rule 72, is one such quick method of calculating how much time it will take, for your investment to double.

So, if you invest Rs 100 with a compounding interest of 10% per annum, the rule of 72 gives 72/10 = 7.2 years as the approximate time frame required for the investment to become Rs 200.

If you equate the same to a larger amount of Rs 100,000 in approximately 7 years, it would grow to 200,000. Remember you will be consistently saving up too, topping up existing funds, hence, if you are planning to retire 60 years from the time of the investment, it will approximately snowball to about 6 times from its original value. This is the avalanche effect of compound interest.

Fortune favours the early bird!

Compounding interest is like wine, yields better results when money is saved over longer durations. So, if you are planning to save crores (millions) for your retirement funds, then start as early as possible, with your first salary or at least by 25 years of age. So, when you retire at the age of 60, you will be sitting on a comfortable pile of money to lead the rest of your life in style.

If you set aside a sum of say Rs 5,000 every month from the age of 25, at a return interest rate of 10%, in 60 years you will have with you funds worth about Rs 1 crore (Rs 10 million) and more. However, if you start at 40 with the same amount and return rate of interest, the retirement fund will amount to only around Rs 33 lakh (Rs 3.3 million).

That is a huge difference, the 40-year-old individual would need to invest several multiples of Rs 5,000 to be able to catch up!

Here is a comparative chart of the approximate retirement funds an individual can lay claim to depending on the age at which he starts saving.

Let us assume the individual plans to invest Rs 10,000, every year at a return interest rate of 10%. You will realise from the chart that starting early counts a lot!

Age at which the investment begins	Retirement fund
20 years	Rs 49 lakh
25 years	Rs 30 lakh
30 years	Rs 18 lakh
35 years	Rs 11 lakh
40 years	Rs 6 lakh

You will notice from the above comparison that even a matter of five years can make a huge dent on how much you retire with.

You could choose to start saving when you are much older and still meet the target retirement fund of Rs 49 lakh (Rs 4.9 million), saved by an individual who started investing from the age of 20.

However, you will need to increase the amount of money you invest to make up for the lost time. This could be a strain on your budget, as you may have to set aside a significant amount of money to reach your goal.

To illustrate, let's see how much more you would need to invest and at what age, for you reach a target of Rs 49 lakh by the time you are 60 years old. Here is a comparison of the approximate increase in the amounts of money you need to shell out every year to reach your target.

Age at which investment begins	Difference in funds invested
20	10,000
25	16,500
30	27,000
35	45,000
40	78,000

You will notice that the more you delay, the more you need to invest. Hence, it makes sense to consistently set aside about 10% of your monthly income for your retirement fund. This will mean your savings will increase correspondingly with your income, enabling you to grow your funds exponentially.

All you need to reap the advantage of compounding interest and save up a significant retirement fund is to invest time, consistency, patience, and savings to obtain a financially secure future, when you need it the most.

Source - [bankbazaar]